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ABSTRACT The effects of accounting restatements on firm growth

Financial statements are an important mechanism to convey firm specific information to dispersed shareholders. Though financial statements are prepared in accordance with Generally Accepted Accounting Principles (GAAP), accounting standards provide discretion which can be used to inflate firm’s income statement and balance sheet accounts, leading to restatements.1 The Securities and Exchange Commission describes restatements as “the most visible indicator of improper accounting – and source of new investigations” (Schroeder, 2001). Graham et al. (2008, p. 44) state that some restatements “reduced previously reported earnings by billions of dollars” and further contend that:

“restatements are potentially very costly to the firms involved. They may shake investor confidence in the credibility of corporate disclosure, depress demand for a firm’s securities, and constrain corporate opportunities thereby leading to a substantial loss in market value.”

Given the importance of restatements, recent research (e.g., Graham et al., 2008; Newberry and Parthasarathy, 2007; Hribar and Jenkins, 2004) has placed great interest in examining the effects of accounting restatements. Graham et al. (2008) focus on debt markets and find an increase in loan spreads and fees following a restatement and find that the effects are more severe for fraudulent restating firms than for non-fraudulent restating firms. In a similar vein, Newberry and Parthasarathy (2007) examine the public debt market and find higher credit-spreads following restatements. Recent evidence also suggests that accounting restatements increase the cost of equity financing (Palmrose et al., 2004; Anderson and Yohn, 2002).

An implication resulting from the higher cost of debt and equity financing is that it will impede firm ability to pursue potentially profitable investment projects. Specifically, if restatements create uncertainty about a firm’s future prospects, they may impede firm ability to obtain lower cost external funds. The inability to access lower cost external financing can limit firm investment and contribute to lower firm growth, particularly externally financed firm growth.

It is also worth noting that restatements can fray existing contracting relationships such as those between the firm and its suppliers and customers (Karpoff et al., 2008). In part, this is viewed as the negative reputational effects of firm restatement and reduces firm cash flows. The reduction in firm cash flows can also negatively impact firm growth, particularly internally financed firm growth.

We follow Demirguc-Kunt and Maksimovic’s approach (1998, 2002) and compute and compare both internally and externally financed growth rates prior to and after the announcement of a restatement. Our sample spans the period from 1997 to 2009 and includes 1,044 restating firms and a matched sample of non-restating firms. A negative relation implies that costly external financing or deterioration in internal cash flows impedes firm ability to pursue potentially profitable investment opportunities. We find, on average, a decline in sales growth rates following restatements which is driven by a decline in externally financed growth rates. Our findings support the argument that restatements negatively impact firm ability to access lower cost external funds, impeding ability to undertake potentially profitable investments. Furthermore, we find the effects are more pronounced for firms that undertake restatements due to fraudulent reporting. We also find that firms with more severe restatements, measured by announcement period market reactions, have lower externally financed growth following restatements.

We contribute to two streams of extant research. We contribute to the literature examining the effects of restatements. Palmrose and Scholz (2004) and Simmons (2011) provide evidence on the legal consequences of restatements. Other prior research has largely focused on the impact of restatements on firm information environment, and the cost of equity and debt financing (Anderson and Yohn, 2002; Palmrose et al., 2004; Graham et al., 2008; Wilson, 2008; Barniv and Cao, 2009). They generally find that restatements lead to deterioration in firm information environment and increase external financing cost. We depart from this line of research in that we focus on whether restatements impose a binding constraint on firm investments and consequently firm growth. Furthermore, our finding that the growth effects of restatement are through its impact on external financing complements the restatement literature which investigates the effect of restatements on cost of capital.

We also contribute to the literature examining firm growth, in particular externally financed firm growth. Prior cross-country research has found that firms in countries that lack institutions to address information asymmetry and agency conflicts, have limited ability to access external funds and hence suffered lower externally financed growth rates (Demirguc Kunt and Maksimovic, 1998). Examining firms within a single country, Khurana et al. (2006) find that firms that adopted a more expanded disclosure policy exhibit greater externally financed growth rates. We contribute to this line of inquiry by examining whether corporate misreporting impedes firm ability to achieve growth through external financing.

Our findings provide information for creditors and analysts who rely on financial planning and externally financed growth to determine the credit worthiness of a firm. Taken together our results will also be of interest to academics, practitioners, and investors who are concerned about the fallout of accounting restatements and firms’ future prospects. From a4 regulatory and standard setter perspective it is useful to have a broad understanding of the consequences of accounting restatement associated with destruction of shareholder wealth including the decrease in firm growth due to the increased cost of external financing. Also relevant to regulators is the finding that more egregious fraudulent accounting restatements lead to a larger punitive decrease in firm growth as compared to restatements due to error, suggesting that firms are punished for their transgressions. As such, our study highlights the merits of enacted statutes such as the Sarbanes-Oxley Act which severely penalizes managers for financial misreporting. These statutes limit opportunistic reporting that can lead to considerable loss of investor wealth.

The rest of the paper is organized as follows: Section 2 reviews the related literature and develops the hypotheses; Section 3 discusses the data and empirical methods; Section 4 presents the results; and Section 5 concludes the paper.